currency risk Flashcards
what is the bid price?
the price at which the market maker or broker is willing to purchase a currency (demand side)
what is the ask price?
price at which the broker will sell the currency (supply)
why is the bid always lower than the ask?
banks make their profit from the spread
what is the “rip-off” rule?
when trading currencies, always apply the rate that results in a higher cost when buying (ask) and a lower return when selling (bid), ensuring the broker or bank’s profitability
what is triangular arbitrage?
trading between 3 different currencies in 3 different countries to exploit discrepancies in currency exchange rates
why is it that there is always a certain risk on triangular arbitrage?
because in practice it’s impossible to complete all these trades simultaneously
what is covered interest rate parity?
a fundamental principle in financial economics that states interest rates differentials between 2 countries are equal to the differential between the forward exchange rate and the spot exchange rate
what are synthetic forwards?
synthetic forwards replicate the effects of traditional forward contracts using other financial instruments like options or the money market instruments
what should the difference between interest rates be approximately equal to?
the percentage difference in exchange rates (forward premium)
observing the differential in interest rates, when is there an arbitrage opportunity?
when the differential more than compensates the differential in exchange
